After the Fall: Why You Should Hold Bonds Even When Yields Are Low

There’s an old saying that I often think of when investors ask why anyone would hold bonds with yields so low: “When you fall, it’s better to land in a net than on the cement.”

Historically, there has been no better hedge against an equity market decline than long-term Treasury bonds. The sharp drop in stocks and other risk assets in late February—fueled by concerns about the spreading COVID-19 coronavirus—underscored that again. It’s why we continue to believe that most investors should have an allocation, however modest, to high-quality bonds of intermediate or longer duration. It can mean the difference between being able to meet your current obligations, including paying taxes, and having to liquidate stocks when the market is plummeting.

Too late for a safety net, but too soon to rush back in

Most of the investors I meet with already have a plan that includes fixed income. However,  some have been content to hold cash or ride the equity wave instead of holding bonds. Up until recently, that was working well. Those holding cash or short-term securities avoided the pain of the drop, but they’ve missed the benefit of the rally in intermediate to long-term bond prices. Year to date, the total return for long-term Treasuries is 9.4%, while short-term core bonds are up just 1.4%.

Meanwhile, investors with equity-only exposure are likely to be more nervous. If they have a long investing time horizon, they can wait out the downturn. If not, they may face a dilemma about what to do now. Yields have fallen so sharply that it’s tough to argue that it’s an opportune time to allocate more to high-quality bonds, such as Treasuries. Yet we believe it’s too early to jump into the riskier segments of the fixed income market, such as high-yield bonds.

10-year Treasury yields dropped as coronavirus outbreak weighed on growth

Source: Bloomberg. Daily data as of 2/28/2020. Past performance is no guarantee of future results.

 

Meanwhile, the 30-year Treasury yield fell to the lowest point of all time

Source: Bloomberg. Daily data as of 2/28/2020. Past performance is no guarantee of future results.

 

While it’s possible we’ll see at least a modest rebound in the coming weeks as the panic buying ebbs, yields can (and probably will) fall further. Yields in the U.S. are still significantly above those in most other major developed countries, and we expect them to get closer to convergence longer term. As the economic toll from the virus becomes more evident, global bond yields are likely to continue falling and U.S. yields have the most room to decline.

Moreover, there is a significant risk of a global recession. So far, the damage from the virus and containment efforts is hardly visible outside of Asia, where China and South Korea are already reeling and putting pressure on the surrounding Asian countries. Italy, Europe’s third-largest manufacturing economy, is now experiencing a serious outbreak in the north. In the U.S., there have been warnings coming from companies about supply chain disruptions, steep drops in travel bookings and port activity.

Very little of it has shown up in economic data yet. By the middle of March, however, we should start seeing data that reflects slower domestic growth due to the epidemic. Companies that are experiencing problems producing their goods due to missing parts, or a drop in demand, may begin to cut back on the hours that employees work. The longer the coronavirus impact lasts, the higher the risk of layoffs. As hours and jobs are lost, income is lost and consumer spending begins to edge lower. As the consumer has been the mainstay of the U.S. economy, that’s the trend to watch.

Central banks likely will cut rates

On the plus side for markets, central banks around the globe have been cutting rates to help offset the economic blow of the coronavirus. In addition, the Group of Seven pledged to take action to address any economic downturn with fiscal policy. While monetary policy is less effective against supply shocks than declines in demand, it can help address some of the second-order effects.

The Federal Reserve’s decision to cut the fed funds rate by 50 basis points to a target range of 1.0% to 1.25% in early March reflected the concerns about the “evolving risks” that the coronavirus poses to the economy. By moving on a rate cut early, Fed officials are hoping to lessen the impact.

However, the market signalsfrom rising volatility to an inverted yield curveare indicating that there is stress that the Fed could address.

Volatility has risen as governments struggle to contain the coronavirus

Notes: Merrill Option Volatility Estimate is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options. Source: Bloomberg. Merrill Option Volatility Estimate (MOVE INDEX). Daily data as of 2/24/2020.

In addition, the Fed will likely see the recent tightening in financial conditions driven by rising credit spreads and falling stock prices as a warning signal for the economy. When financial conditions tighten, it can mean that businesses have difficulty obtaining capital at a reasonable cost.

COVID-19 concerns weighed heavily on financial conditions

Note: The Bloomberg U.S. Financial Conditions Index tracks the overall level of financial stress in the U.S. money, bond, and equity markets to help assess the availability and cost of credit. A positive value indicates accommodative financial conditions, while a negative value indicates tighter financial conditions relative to pre-crisis norms. Source: Bloomberg. Bloomberg U.S. Financial Conditions Index (BFCIUS Index), daily data as of 2/28/2020.

Lastly Fed easing will likely “un-invert” the three-month/10-year Treasury yield curve, as it did last year. If Fed rate cuts are seen as timely and beneficial for the economy, the yield curve should steepen, with short-term rates falling faster than long-term rates.

The three-month/10-year Treasury yield curve inverted in February

Source: Bloomberg as of 2/28/2020 and 1/28/2020.

 

Time is on your side

As the epidemic plays out, investors will need to think about timing if they want to reallocate their holdings. With a well-thought-out financial plan, the best action to take may be no action. Eventually the number of new cases will peak, or there may even be a vaccine to protect against the coronavirus. China is beginning to get back to work, albeit slowly, which should help stabilize its economy and restore disrupted global supply chains. Actions by central banks and governments will help mitigate some of the damage while populations and economies heal.

For fixed income investors, signs of recovery will likely mean a rise in yields. Consequently, we wouldn’t chase long-duration bonds at current levels. At this point, we would look for 10-year Treasury yields to be capped at under 1.5%. For investors looking at riskier segments of the market, there should be opportunities down the road to add to positions at more attractive levels.

For most investors, however, adding risk may not be the best option. The fixed income allocation in their portfolios is not where they choose to take a lot of risk. It’s the safety net.

 

1 A basis point is one one-hundredth of one percent, or 0.01%.

About the author

Kathy Jones

Senior Vice President, Chief Fixed Income Strategist, Schwab Center for Financial Research